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Fixed-income investors are resting a little easier these days. Bonds are generating decent yields for the first time in almost 20 years and the risk of interest rate hikes has diminished. In fact, interest rates have stabilized and conditions are more likely to lead to bond values rising should central bonds reduce interest rates, as expected, in 2024.
“Fairly attractive opportunities from a fixed-income standpoint have emerged today, especially for safe securities such as U.S. government bonds,” says Mike Dragosits, portfolio manager at Harvest Portfolios Group Inc. in Oakville, Ont. “These investments are now about as attractive as they’ve been in decades.”
Yet, for advisors and their income-hungry clients, including many retirees, the challenge of creating a prudent income strategy remains.
Bond yields may be at 4 to 5 per cent, but coupon income alone may not feel all that comfortable with inflation’s direction still uncertain. What’s more, creating a prudent income strategy is difficult even for well-heeled investors.
“The universe of bond securities is vast,” Mr. Dragosits says.
He notes the fixed-income market is multiples the size of the equity market. Choices abound, yet access to all fixed-income securities and strategies is limited, even for advisors. Until recently in Canada, that has included covered-call fixed-income exchange-traded funds (ETFs), which have been around for years in the U.S.
These investment funds bear closer examination by advisors and do-it-yourself investors. They can offer significantly higher income from the fixed-income side of the portfolio than traditional bonds or bond funds alone.
This strategy involves selling covered-call options on a portion of the portfolio’s fixed-income holdings. The premiums generate consistent monthly cash flow, complementing coupon income from underlying bonds.
“You’re giving up some upside in a situation in which yields fall rapidly in a compressed time period, but overall, there are a lot of benefits to a covered-call strategy,” Mr. Dragosits says.
Harvest is among the first ETF providers in Canada to offer a covered-call fixed-income strategy with the recent launch of Harvest Premium Yield Treasury ETF HPYT-T in September 2023, followed by a U.S. dollar class offering this January.
The ETF holds a portfolio of long-duration U.S. fixed-income ETFs, including iShares 20+ Year Treasury Bond ETF TLT-Q and Vanguard Long-Term Treasury ETF VGLT-Q. The portfolio management team for the Harvest ETF writes monthly call options on up to 100 per cent of the holdings in the fund.
The cash flow generated from the call option premiums is often significantly higher than what the underlying bond coupons can generate on their own, Mr. Dragosits says.
Harvest Premium Yield Treasury ETF’s target monthly distribution is 15 cents per unit, or about $150 a month per 1,000 units. It aims to generate most of this distribution from call option premiums, written monthly on the underlying bond funds held in the Harvest ETF. “Typically, we write these options 1 to 2 per cent out of the money,” Mr. Dragosits says.
What happens if the underlying bond fund prices exceed their strike price, rising more than 1 to 2 per cent in any given month, which is significant for fixed income? Then, the ETF’s upside for capital gains will be limited compared with a non-covered call bond ETF.
“Still, the collection of the monthly option premium offsets some of that risk,” Mr. Dragosits says.
Remember, he adds, the main reason for a covered-call strategy is generating additional cash flow, with capital growth of the assets being secondary.
A covered-call strategy is designed to create monthly, tax-efficient cash distributions. Premiums aren’t fully taxable like coupon payments (interest). Rather, premiums receive the same tax treatment as capital gains, so only 50 per cent of the income is taxable.
Harvest is already well known for its suite of covered-call equity ETFs, including Harvest Healthcare Leaders Income ETF HHL-T and Harvest Tech Achievers Growth & Income ETF HTA-T. Now, it aims to lead the Canadian market for covered-call bond ETFs too. Along with Harvest Premium Yield Treasury ETF, the firm unveiled Harvest Premium Yield 7-10 Year Treasury ETF HPYM-T, which has set a monthly distribution of eight cents per unit at launch.
“It offers the same strategy as HPYT, but its underlying bond holdings have a lower duration and, in turn, less volatility,” Mr. Dragosits explains. “That means HPYM is less price sensitive to interest rates, although it likely offers less monthly cash flow than HPYT, which holds longer-duration bonds that typically generate more yield and higher premiums.”
Harvest has also just launched another complementary product, Harvest Canadian T-Bill ETF TBIL-T, which holds Canadian treasury bills maturing in less than three months and pays a monthly distribution. “This [ETF] is for investors who don’t want volatility or covered calls generating premiums for additional income,” Mr. Dragosits says.
Whether Harvest’s fixed-income ETFs use a covered call strategy or not, they’re designed to generate steady income.
“If you’re looking for tactical bond strategies to generate capital gains, these ETFs are not what you want,” Mr. Dragosits says. “But if you seek consistent monthly cash flow over what traditional bonds can provide, they’re worth a closer look.”
Advertising feature produced by Globe Content Studio with Harvest Portfolios Group. The Globe’s editorial department was not involved.